Foreign institutional investors (FIIs) have approached the ministry of finance (MoF) seeking an extension of the feedback window on the new direct tax code. People familiar with the issue told ET that the deadline for submitting feedback has lapsed. Terming the window insufficient for a detailed response, FIIs have asked for an extension.

There is a perception that if implemented, the direct tax code could increase tax liabilities of foreign portfolio managers significantly. So far in 2009, FIIs have pumped in $8.6 billion into Indian equities. As of September 15, 2009, there are around 1,695 Sebi-registered FIIs in India.

Under the proposed tax code, securities transaction tax (STT) will be abolished and tax on long-term gains will be brought back. The code proposes that FIIs will be taxed at a flat rate of 30% on net capital gains as against nil/10%/20% on long-term capital gains and 15%/30% on short-term capital gains under the existing law.

It also introduces general anti-avoidance rules (GAAR), under which any transaction could be considered to be a tax avoidance transaction and the onus for proving otherwise is on the tax payer. Currently, double taxation avoidance agreements (DTAA) override the domestic law.

There are concerns that GAAR could be used against even genuine transactions, thereby affecting portfolio flows into the country. However, the new code proposes that the provisions under the act or DTAA, whichever is later in time, shall prevail. This negates the provisions of more than 70-odd comprehensive DTAAs, which India has signed with other countries, thereby eroding the subsequent tax benefits. Experts believe the ownership structure of FIIs could be impacted and there would be need for re-organisation.

Clearly the proposed code is a negative for FIIs and will impact inflows (if implemented). FIIs may also need to restructure their operations to assess the tax beneficial ways, in which they could invest in India, said Akhil Hirani, managing partner of Majmudar & Co.

The concern among the institutional investors is palpable. They are concerned that the domestic tax rule will override international treaties, ie GAAR will override DTAA. Additionally, almost 50% of the registered funds are coming through the DTAA route. So, effectively they will end up paying double taxes, said a person familiar with the issue.

Interestingly, both Mauritius and Singapore, have signed double tax avoidance treaties with India. As per custodians, over 50% of the money comes in via the Mauritius route.

The new tax code if implemented will only benefit those who churn portfolios frequently. The larger chunk of FIIs are long-only funds. For them, 30% tax will be a huge chunk of their profits, as it will be moved into business income, said an official. There is a growing perception amongst FIIs that while India is an exciting market, frequent regulatory changes make it a very complex market to invest in.